Undervaluation Alpha: Analyzing the Returns to Analyst-Claimed Mispricing

Abstract

We study the mispricing information in US and international analysts’ target prices. We hypothesize that asymmetry in the value-relevance of information that firms supply to analysts, and asymmetry in how analysts convert such information into their target prices, lead to asymmetry in the predictive properties of analyst-claimed mispricing. Specifically, we propose that analyst-claimed undervaluation will be more predictive of future returns than will analyst-claimed overvaluation. Our tests first isolate analyst-claimed mispricing by removing analysts’ estimates of the cost of equity from the returns implied by their target prices, then separate analyst-claimed undervaluation from overvaluation. Empirically we find that target prices only predict future returns (at between 15¢ and 19¢ on the dollar) when analysts claim undervaluation, not when they claim overvaluation. In additional analyses, we find that analyst-claimed undervaluation predicts future returns more strongly after firms experience low returns and when uncertainty in the overall stock market is low.